Over the past two decades, environmental, social, and governance (ESG) considerations have become increasingly important for investors as the world wakes up to the challenges of sustainability.

Emerging markets are particularly exposed to many of the issues that threaten our planet. That makes the need for ESG practices acute. But as governments, regulators and companies act to enhance sustainability, investors can benefit from improving ESG standards. In this article, we outline some of the ESG opportunities we see in emerging market debt (EMD) over the next few years.

Data transparency

A key consideration for ESG-conscious investors is data transparency. Currently, emerging market bond issuers lag their counterparts in developed markets, where ESG disclosures are the norm. However, there is an opportunity for ESG-minded investors to work with companies to help improve their data and ESG reporting. This should improve those companies' ESG ratings, which in turn will help to improve the performance of their bonds.

Issuance is building from a low base … and taking on a greener tinge

Bond issuance in emerging markets is well below that in developed markets, both absolutely and as a proportion of GDP (gross domestic product). This situation is improving, however, with both countries and companies increasing their issuance – offering investors a broadening opportunity to tap into the higher growth prospects of developing economies.

One important indicator of emerging market companies’ changing attitudes is the growing focus on environmental objectives. In recent years, we've seen a significant shift in new issuance towards green bonds, the proceeds of which are used to finance climate- or environment-related projects, assets, or activities. In 2015, green bonds accounted for just 1% of new bond issuance in emerging markets. By 2022, their share had increased to 30% (Chart 2). Despite a slump last year when its economy was locked down, China is the second-largest issuer of green bonds, trailing only the US.

Chart 1. Uptick in labelled bonds issuance in EM

Source: JPM, January 2023.

According to the IFC (International Finance Corporation), green bond issuance in emerging markets is set to dip this year, largely because of China's protracted emergence from the pandemic.1 But issuance should recover strongly in 2024 and continue on its robust growth trajectory.

As the issuance of green bonds and sustainable funds becomes more mainstream in emerging markets, the greenium (the premium investors have been willing to pay for green bonds over non-green issues with equivalent coupons and maturities) should increase. In turn, this should make returns from green bonds more attractive, with the additional benefit of advancing the sustainability agenda.

A growing financing gap

Another key ESG opportunity in emerging markets relates to the United Nations' Sustainable Development Goals (UN SDGs). The UN published the 17 SDGs in 2015. Collectively, they form a "blueprint for a better and more sustainable future for all," with an initial target of completion by 2030.

The SDGs address the world's major sustainability challenges, including peace, justice, poverty, inequality, climate change, and environmental degradation. All 193 UN member states have committed to the SDGs, along with an agreed set of milestones. There have been many failures in meeting these milestones, however.

One of the key challenges is the financing gap. Before COVID, the shortfall in the finance available to meet the SDGs in emerging markets was US$2.5 trillion a year. By 2020, this annual requirement had increased to US$4.2 trillion.2 Since early 2022, Russia's invasion of Ukraine and the consequent food and energy shocks have widened the gap further.3 Clearly, the financial industry has a vital role to play in filling this gap.

This market is still in its infancy.

This market is still in its infancy. So far, emerging market investors have just begun to allocate capital towards sustainability. This leaves ample room for growth. For example, only 7% of emerging market equity portfolios are ESG funds, compared with 17% in European equities. In fixed income, just 6% of emerging market credit funds are ESG funds; in euro credit, this figure is above 30%.

There is both an urgent need and a huge opportunity.

There is both an urgent need and a huge opportunity. By financing the companies and projects addressing the SDGs, investors are channeling capital into areas of huge demand growth. For example, demand for clean energy technologies such as batteries is projected to grow this year as this nascent trend accelerates. Indeed, according to the International Energy Agency (IEA), investment in battery systems should total around US$37 billion this year.

Meanwhile, as Chart 3 shows, investment in solar energy has outstripped investment in oil for the first time.

Chart 2. Solar overtakes oil

Source: IEA. Licence: CC BY 4.0.

The companies that operate in these high-growth areas are therefore well-positioned to advance the ESG agenda and deliver attractive returns to equity and bond investors.

Do younger boards offer emerging markets an edge?

Governance is a crucial part of ESG – arguably the most crucial, in that it ultimately controls companies' behavior on the environmental and social fronts. Given emerging market demographics, those companies that address sustainability challenges are likely to be at an advantage.

We're seeing a growing divergence between developed and emerging markets in the profiles of their corporate boards. In the developed world, the average age of new directors has been rising steadily towards 60.4 This year, for example, male directors appointed to the boards of S&P 500 companies will average around 58 years of age.5

In emerging markets, however, directors tend to be significantly younger – as do female directors in both developed and emerging markets.4 This may have important implications for how emerging market companies embrace the opportunities presented by new technology. Younger, more dynamic boards are likely more open to adopting technological solutions to social and environmental challenges. They may therefore offer emerging market companies an advantage over more entrenched competitors. Given emerging markets' exposure to environmental and social threats, this could be a welcome development – and something that ESG-minded investors should consider.

Final thoughts

There is no doubt that emerging markets are in urgent need of investment in clean energy, climate technology and other crucial areas of sustainable development. A rigorous ESG approach can help ensure that investors’ capital is advancing – or at least not hindering – progress in these areas while seeking positive financial returns.

But there’s another way of looking at ESG. Or rather, ESG offers another way of looking at investments. The traditional view of emerging markets is that they are inherently riskier than their developed equivalents. At the country level, this often reflects relatively immature institutions, evolving economies, and greater potential for political turbulence. At the corporate level, it can encapsulate political interference or influence, potential for corruption and lack of transparency. ESG offers a useful lens through which to scrutinize companies and assess their creditworthiness.

At a time when ESG is under attack and is increasingly politicized, its value as a tool for measuring risk should not be understated.

The value of investments and the income from them can go down as well as up, and investors may get back less than the amount invested.

1 "Emerging Market Green Bonds." IFC, July 2023. https://www.ifc.org/en/insights-reports/2023/emerging-market-green-bonds-report.
2 "Scoping-Note-Closing-SDG-Financing-Gap-COVID-19-era." OECD, November 2021. https://web-archive.oecd.org/2021-11-17/616672-OECD-UNDP-Scoping-Note-Closing-SDG-Financing-Gap-COVID-19-era.pdf.
3 "Sustainable Development Goal Alignment for a Just and Sustainable Recovery." Global Outlook on Financing for Sustainable Development 2023, November 2022. https://www.oecd-ilibrary.org/finance-and-investment/global-outlook-on-financing-for-sustainable-development.
4 "Building the Corporate Boards of the Future." MSCI, January 2023. https://www.msci.com/www/blog-posts/building-the-corporate-boards/03610156236.
5 "2023 S&P 500  New Director and Diversity Snapshot." SpencerStuart, August 2023. https://www.spencerstuart.com/-/media/2023/august/usbi2023/director_diversity/2023_new_director_-diversity_snapshot.pdf.